Mean Reversion in Stock Prices in an Emerging Market : Sri Lankan Evidence

This paper examines long-horizon predictability of stock prices in Sri Lanka using 1-4 year real returns on indices for market and industry portfolio during the 1985-97 period. In a model of prices, which contains a random walk component and a slowly decaying transitory price component, which are uncorrelated, the slope of regression of returns of certain period on lagged return of equal length measures the predictable variation of returns. The results show that, consistent with the predictions of the model and findings of previous research, long-horizon returns in Sri Lanka are highly negatively correlated implying mean reversion. Predictable variation in 1-3 year returns is very large in the order of about 50 percent. The results also reliably reject the random walk behaviour of prices